288 Part 3 Financial Assets
HD also needs to increase its working capital, especially inventory. Putting
everything together, HD generates positive free cash " ow for its investors if and
only if the money from its existing stores exceeds the money required to build and
equip its new stores.9-7a The Corporate Valuation Model
In Chapter 3, we explained that a! rm’s value is determined by its ability to gener-
ate cash " ow both now and in the future. Therefore, its market value can be
expressed as follows:Mark et Value
of company(^)! VCompany! PV of expected future free cash! ows
9-7!
FCF 1
(1 " WACC)^1
"
FCF 2
(1 " WACC)^2
"... "
FCF#
(1 " WACC)#
Here FCFt is the free cash " ow in Year t; and the discount rate, the WACC, is the
weighted average cost of all the! rm’s capital. When thinking about the WACC,
note these two points:
- The! rm! nances with debt, preferred stock, and common equity. The WACC
is the weighted average of these three types of capital, and we discuss it in
detail in Chapter 10. - Free cash " ow is the cash generated before any payments are made to any investors;
so it must be used to compensate common stockholders, preferred stockholders, and
bondholders. Moreover, each type of investor has a required rate of return; and
the weighted average of those returns is the WACC, which is used to discount
the free cash " ows.
Free cash " ows are generally forecasted for 5 to 10 years, after which it is assumed
that the! nal explicitly forecasted FCF will grow at some long-run constant rate.
Once the company reaches its horizon date, when cash " ows begin to grow at a
constant rate, we can use the following formula to calculate the market value of
the company as of that date:
9-8 Horizon value! VCompany at t! N! FCFN " 1 /(WACC $ gFCF)The corporate model is applied internally by the! rm’s! nancial staff and by
outside security analysts. For illustrative purposes, we discuss an analysis
conducted by Susan Buskirk, senior food analyst for the investment banking! rm
Morton Staley and Company. Her analysis is summarized in Table 9-2, which was
reproduced from the chapter Excel model.- Based on Allied’s history and Buskirk’s knowledge of the! rm’s business plan,
she estimated sales, costs, and cash " ows on an annual basis for 5 years.
Growth will vary during those years, but she assumes that things will stabilize
and growth will be constant after the! fth year. She would have made explicit
forecasts for more years if she thought it would take longer to reach a steady-
state, constant growth situation. - Buskirk next calculated the expected free cash " ows (FCFs) for each of the 5
nonconstant growth years, and she found the PV of those cash " ows dis-
counted at the WACC. - After Year 5, she assumed that FCF growth would be constant; hence, the con-
stant growth model could be used to! nd Allied’s total market value at Year 5.
This “horizon, or terminal, value” is the sum of the PVs of the FCFs from
Year 6 on out into the future, discounted back to Year 5 at the WACC. It follows
that: Horizon Value at t " 5 " FCF 6 /(WACC – gFCF), where gFCF represents the
long-run growth rate of free cash " ow.